Have you ever thought of dividends as a reward for long-term investors? Every quarter, certain public companies pay out dividends to their shareholders, who can then use them as income or reinvest them back into the company. But since company stock only needs to be held for a day for dividend eligibility, many short-term traders like to play a game called "capture the dividend." 

By employing a dividend capture strategy, investors with short-time horizons can receive payouts without worrying about the stock's long-term prospects.

Overview of the Dividend Capture Strategy

Also known as dividend harvesting or dividend scalping, the dividend capture strategy enables day or swing traders to benefit without needing to hold the underlying stock long term. Dividend capture is a short-term trading strategy aimed at reaping income from the dividend of blue chip or high-yield stocks through timely entry and exits. Since a stock only needs to be held for a day to receive the dividend, crafty traders can bounce in and out of stocks and still get rewarded.

Dividends are excess portions of a company's net profits. The company can either reinvest its extra profits into the firm or reward them to shareholders through dividend payouts. Dividends usually come from established companies that aren't aiming at accelerating growth or expanding market share, which is why older blue chip stocks tend to pay the highest dividends.

Dividend Timeline

Before buying any stocks, you'll need to make a dividend capture strategy calendar. Your calendar will consist of the four major dates on the dividend calendar, even though investors need only be aware of one:

• Declaration date: On the declaration date, companies announce when the next dividend will be paid (if any) and how much the payout will be. The declaration date also announces the date of record, or when investors must be on the books for dividend eligibility. 
• Ex-dividend date: The date of record gets announced before the ex-dividend date, but the ex-dividend date comes first sequentially. The ex-dividend date is the most important date on the calendar for investors since they must own the stock before this day to receive the dividend. The date of record might be when investors' names go in the books, but the ex-dividend date is the cutoff set by exchanges. The ex-dividend date occurs a day or two before the date of record to allow trades to settle, and the company can assess the proper ownership stakes.
• Date of record: On the date of record, the company paying the dividend will note which investors are eligible to receive it. The date of record occurs after the ex-dividend date to allow trade settlement to occur. Investors need to take no action on the record date; it's merely for company bookkeeping.
• Payout date: Finally, the dividend payout hits brokerage accounts on the payout date. The payout date comes from the company issuing the dividend, but an investor does not need to own shares on this date to get the dividend. Shares may have changed hands several times between the ex-dividend date and the payout, but the investor who owned the shares at closing time the day before the ex-dividend date gets the payout.

How Does the Dividend Capture Strategy Work?

Dividend capture works by purchasing the stock before the ex-dividend date and then selling it on or after the ex-dividend date. While it's important to understand the dividend calendar so you know how much the dividend will be and when you will receive the payout, the ex-dividend date is the critical day to be aware of when using this strategy.

Remember, you only need to hold the stock overnight on the day before the ex-dividend date to receive the payout. If you wish to sell the stock soon after the morning bell on the ex-dividend date, you can do so and will still receive the dividend on the payout date. Since the holding period for dividend eligibility is a single day (in reality, only a handful of hours), short-term traders can time their buys and sells to coincide with the dividend calendar of their preferred companies.

Example of How to Use the Dividend Capture Strategy

Here's an example of this dividend strategy. Let's say you want to capture the dividend for the 3M Company (NYSE: MMM) and the United Parcel Service Inc. (NYSE: UPS). Both companies are blue-chip stocks with a long history of raising dividend payouts, which makes them ideal securities for dividend trading.

First, you'll need to look at the dividend calendar for both companies. If you're using a dividend capture strategy, you'll want to know all four key dates, especially the ex-dividend date and the payout date. The ex-dividend date tells you when you must own the shares, and the payout date tells you when to expect your reward to hit your brokerage account. Gazing at the calendar, you notice that 3M has an ex-dividend date of February 16, and UPS has an ex-dividend date of February 17. Then, you notice that UPS has a payout date of February 28, while 3M doesn't pay until March 10. (You can use MarketBeat's dividend screener to find a comprehensive list of these dates.)

To utilize this dividend strategy, you can buy shares of 3M on February 15 and hold them overnight. At the ringing of the opening bell on February 16, you can sell your 3M shares and use the proceeds to buy UPS shares. As long as you hold the UPS shares through close, you're eligible to receive both dividends, even though you've only held each stock for a single day. Note that good faith violations (GFV) can occur if you buy and sell stocks with unsettled funds, so you may need to hold the UPS shares beyond a single day to avoid getting dinged by a GFV.

Tax Implications of the Dividend Capture Strategy

Taxes represent one of the downsides of the dividend capture strategy. Not all dividends are created equal: they can be qualified or unqualified. A qualified dividend is eligible for the preferential capital gains tax rates, which can be 0%, 15% or 20%, depending on your income. Unqualified dividends are subject to ordinary income tax rates, which can be as high as 39% if you're in the top tax bracket. 

Long-term investors benefit most from dividends because they hold stocks long enough to meet the standards for qualification. To be classified as a qualified dividend, the investor receiving the payout must have held the stock for a minimum of 60 days. Any 60 days during a specific 121-day window will qualify the dividend, but for investors using dividend capture, this holding period is untenable to their strategy. Therefore, dividend capture investors will likely pay the full ordinary income rate on their dividend earnings. As always, consider these factors when deciding when to sell dividend stocks.

Pros and Cons of the Dividend Capture Strategy

Here are a few benefits and drawbacks of deploying a dividend capture strategy:

Pros

First, the pros: 

• Simple strategy: Dividend capture trading doesn't require a detailed understanding of company balance sheets or fundamentals, nor must you be an expert on deciphering chart patterns. Very little market research is required to use dividend capture; you must be aware of the calendar and the payout amounts.
• Don't need to commit capital long-term: Traders using this dividend strategy can remain day or swing traders and still receive the payout. Since stocks only need to be held for a day to get dividends, no long-term capital commitment is required to orchestrate these types of trades. 
• Consistent and immediate rewards: Dividend capture strategies are relatively predictable compared to other forms of short-term trading. The dates you must buy shares are known well in advance, and the company always declares the dividend payout amount well before the ex-dividend date. Unlike a box of chocolates, you know exactly what you'll get with dividend capture.

Cons

Next, the downsides:

• Not tax efficient: Unless you hold the stock for 60 days, dividends are labeled "unqualified" and taxed at your ordinary income rate. No matter your income level, the ordinary rate will always be less friendly than the capital gains rate.
• Market compensates for dividends: Mr. Market is aware of the dividend capture strategy and frequently enjoys throwing a wrench into the gears. Since the ex-dividend date is known well in advance, stocks tend to underperform on that day since buyers are no longer eligible for the payment. If you earn a 2% dividend, but the stock falls by 2% on the ex-date, you're only breaking even (or worse, considering transaction costs).
• Could underperform typical buy-and-hold techniques: Capture techniques are easy dividend trading strategies to understand but challenging to master. You won't get preferential tax treatment and may even lose money if the stock drops precipitously on the ex-dividend date. Dividend capture is more effective during bull markets than bear markets, but there's no promise of outperforming buy-and-hold investors even then.

Dividend Capture May not Outperform other Techniques

Dividend capture can be an effective short-term trading strategy in certain markets, but it's not a plan to gain long-term wealth. Dividend harvesting can provide steady and reliable income without worrying too much about volatile market gyrations or confusing technical analysis. However, dividend capture strategies are very tax inefficient and aren't proven to outperform the long-term techniques of typical dividend investors.

FAQs

Here are a few frequently asked questions about dividend capture strategies:

Can you make money with dividend capture?

With careful planning and timely trading, dividend capture can be an effective income-producing strategy for short-term investments like day trading or swing trading. Learn more about recent dividend increases on MarketBeat.

How effective is dividend capture?

The effectiveness of dividend capture is debatable. In some markets, you can capture the dividend without the stock suffering too much of a hit on the ex-dividend date. But in declining markets, the dividend payout might be negated by the stock price dropping on the ex-date.

How is the dividend capture strategy taxed?

Since you hold stocks purchased using dividend capture strategies for only a day or two, the payouts will be subject to the investor's ordinary income level. You must keep the stock for a minimum of 60 days to receive the more beneficial capital gains rate, which is too long to lock up capital for many short-term traders.